Background

A community bank supervised by the Office of the Comptroller of the Currency (OCC) appealed to the Ombudsman certain determinations made by the supervisory office from a recent review of the bank’s treatment of purchased mortgage loan interests. In this arrangement, the bank purchases mortgage loan interests from unaffiliated, third-party originators. The originator signs a commitment to sell the loan to an investor. Specifically, the bank appealed the supervisory office’s determinations that (i) mortgage loan interests acquired pursuant to the bank’s mortgage warehouse lending business should be classified on the Consolidated Reports of Condition and Income (call report) as “loans to nondepository financial institutions,” (ii) the mortgage loan interests should be assigned a 100 percent risk weight for purposes of calculating the bank’s risk-based capital ratios, and (iii) the bank should amend its year-end call report to reflect the new risk weight assignment and classification of mortgage interests.

Discussion

Call Report Classification: The bank’s appeal asserted that the OCC made material misstatements related to the bank’s mortgage warehouse business that formed the foundation of its final decision. These statements concern the source of repayment, rights to dispose of loan interests, and exposure. First, the bank contended that the OCC manufactured the theory that the bank is ultimately looking to the mortgage originator for the repayment of the obligations. The bank stated that the bank has sole and direct ownership rights and interests in all payments made on or attributable to the mortgage loan interests. Second, the bank said the OCC’s statement that the bank has limited rights to dispose of the underlying mortgage interests because the assets are subject to a takeout commitment is false. The bank contended that its purchased mortgage loan interests are not actually subject to a legally binding takeout commitment. Lastly, the bank stated that the OCC’s statement that the bank does not have the direct exposure of a loan secured by a first mortgage on a one-to-four-family residential property is incorrect. The bank stated that legal counsel’s opinion is that the bank owns the mortgage loan interests and they are secured by one-to-four-family properties; therefore, the bank is exposed to market, operational, liquidity, and credit risks.

Determination of Regulatory Capital Treatment: The bank’s appeal asserted that the character and ownership of an asset should control its risk weight. The appeal stated that the only relevant question for determining the risk weight of the mortgage loan interests at any time under 12 CFR 3, appendix A, is whether the bank, by virtue of its ownership of mortgage loan interests, has ownership interests in loans that are secured by first mortgages on one-to-four-family residential properties at such time. The bank further asserted that any OCC determination of how to classify the mortgage interests must be based on the legal characterizations of the exposures. The bank also argued that the OCC must apply the same classification for the mortgage interests as for all statutory and regulatory purposes. Further, the bank stated that the OCC pointed only to accounting standards as the reasoning behind forcing the bank to change how it risk-weights its mortgage loan interests.

Determination to Refile the Year-End Call Report: The bank’s appeal stated that there is no authority pursuant to which the OCC can require the bank to amend its year-end call report. Further, the bank stated that there was no legal, regulatory, or accounting action implemented that would have required the bank to classify its mortgage loan interests differently than it had in previous call reports.

Call Report Classification: The primary and most relevant decision factor is whether the bank’s purchases qualify for sales treatment under generally accepted accounting principles, specifically ASC 860. Based on his review, the Ombudsman drew the following conclusions regarding the bank’s purchase of mortgage loan interests:

The transaction does not meet the definition of participating interest or sale for purposes of ASC 860.

Whether or not the assets are subject to a takeout commitment is not relevant because the bank’s arrangement fails sales requirements of ASC 860.

The bank’s assertion as to who gets the benefit from the liens on the property is not relevant because the structure of the agreement does not provide the risks and rewards of ownership to the bank.

While the bank’s legal opinion asserts that the terms of the agreement create a legal sale between the parties, and therefore the bank owns the mortgage loans, that opinion does not supersede the call report requirements that transfers of assets must meet certain requirements of ASC 860 to be considered a sale.

The bank’s purchases of mortgage interests represent commercial warehouse lending whereby the bank advances funds under a guidance line of credit to mortgage originators, purchases an undivided interest in a mortgage loan and note, and is repaid primarily from sales to investors.

The Ombudsman’s review found, based upon the terms of the bank’s mortgage warehouse agreement and the guidance in ASC 860, that the bank’s arrangements with the originators do not qualify as participating interests or sales. The warehouse agreement reflects that cash flows are not shared entirely on a pro rata basis and the seller’s rights are subordinate to the bank’s participation interests in the mortgage loans. These conditions preclude qualification as a participating interest. Furthermore, sales treatment is precluded because the originator retains effective control due to its unlimited repurchase obligation at a fixed price.

Determination of Regulatory Capital Treatment: In arriving at a determination, the Ombudsman reviewed issues of legal ownership of mortgage interests, regulatory consistency, and economic perspective. The Ombudsman determined that the OCC is not required to base the interpretation of its capital rules on the bank’s legal characterization. Because the OCC is not relying on the legal characterization of the mortgage interests in making that interpretation, bank counsel’s sale opinion is not relevant. Additionally, there is no statute that compels the OCC to treat interests identically under different statutes or regulations, particularly when those statutes or regulations have different purposes. Finally, the Ombudsman’s review of the asset found that it is more similar to a commercial loan to an originator than a residential loan to a borrower. The loan serves as collateral for the advancement of funds to the originator. While the risk-based capital rules do recognize the risk-mitigating effects of certain types of collateral by allowing a bank to assign the risk weight of the collateral to the collateralized loan, only cash and certain government and government agency securities are recognized as such risk-mitigating collateral. The risk-based capital rules do not provide for a preferential risk weight for assets collateralized by a residential mortgage loan.

Based on these factors, the Ombudsman determined that the appropriate risk weight for the bank’s purchased mortgage interests is 100 percent. The Ombudsman requested that the bank report its purchased mortgage interests under call report Schedule RC-R – Regulatory Capital, item 39 column F, unless held for sale, in which case the purchased mortgage interests should be reported under item 38 column F. In either case, the reporting of the purchased mortgage interests in column F results in the assets receiving 100 percent risk weight.

Determination to Refile the Year-End Call Report: The call report glossary states that when a bank’s primary regulatory agency determines that the bank’s call report contains a material accounting error, it may be directed to file amended condition or income report data for each prior period that was significantly affected by the error. Normally, such refilings do not result in restatements of reports for periods exceeding five years. The call report instructions also reflect universal and longstanding practice among the banking agencies to require filing amended call reports when a bank’s primary federal supervisor believes a previously submitted call report contains significant errors. This is true whether a bank submitted information intentionally or by mistake. The practice of amending call reports is supported by express statutory authority, and evidenced by the statutory penalties for incorrect filings. Therefore, the OCC has authority to require a bank to amend its call reports to correct an error. Finally, material accounting errors typically require restatement for the comparable periods shown on a financial statement. ASC 250 states that when financial statements are restated to correct an error, the entity shall disclose that its previously issued financial statements have been restated, along with a description of the nature of the error.

The Ombudsman determined that the bank’s recharacterization of its purchased mortgage interests and the impact of that recharacterization on the bank’s risk-based capital ratios is material to the bank’s Prompt Corrective Action category for the year end in question and is material to the comparable reporting period of the previous year end. The bank’s tier 1 risk-based capital ratio and its total risk-based capital ratio would have declined by more than 100 basis points for both year ends, which was a material change in these regulatory capital ratios. Capital ratios are also an important consideration in examiners’ assessment of regulatory capital adequacy.

Based on the aforementioned, the Ombudsman determined that, since these accounting errors materially impact the call report from both year-end call report periods, and call reports do not contain comparable information from prior periods, the bank needed to amend both year-end call reports to be consistent with the intent of ASC 250.